What Is the Right Weighting to U.S. Equities?
- U.S. equities still look overpriced, which is a concern to us. They make up around 55% of the global stock universe, which we believe is likely too high for a multi-asset investor.
- We believe the right weighting should take valuations into account, however the weighting must also align to the objective of the portfolio.
- Among the many things to consider, positioning should take into account the opportunity set, any portfolio constraints, costs, risk management and diversification.
Dealing with an expensive market
It is useful to remember that the U.S. equity market has enjoyed a bull run that had lasted longer than nine and a half years. For nearly two of those past years, our investment team has cast a wary eye at the U.S. market, uncertain how long the good times might keep rolling. However, our growing voice on the overpriced nature of U.S. stocks may have led to misunderstanding about our views on this unique asset class. So, to address the issue, we’d like to take a step back and consider a broader question: What’s the right weighting to U.S. stocks?
Valuations drive our asset allocation decisions
Determining the right weighting to an asset like U.S. stocks comes in at least four stages: a) determining the right baseline or neutral weighting if conditions were “normal”, b) understanding the valuations for U.S. stocks, c) understanding the valuations of other asset classes, and d) thinking about risk management. Let’s take valuations first.
Our central theory of investing—shared by value investors through time and around the world—is that an investor raises the probability for a good outcome if the price paid for an investment is less than its intrinsic worth. That is, we base our asset allocation decisions mainly on valuation, or a comparison of an asset’s price to what we think it’s worth. Estimating a stock’s worth is difficult, though. We believe the market usually prices securities quite effectively and efficiently, but history has shown that periods of irrational decision making recur. These are the situations we want to take advantage of—to buy assets when they’re underpriced and sell before they get overpriced.
With that in mind, we turn to U.S. stocks. Cyclically-adjusted price/earnings ratio (CAPE10)—one measure of stock valuation—has risen much faster and higher for U.S stocks than the ratios for stocks in Europe and emerging markets. We believe there’s plenty of evidence supporting our view that U.S. stocks remain overpriced. Indeed, our valuation estimates have led us to underweight U.S. stocks in our portfolios, but depending on the objective of the portfolio, we haven’t abandoned them.
We haven’t abandoned U.S. stocks
This gets us back to the first phase of deciding the weight for an asset class. Put simply, what should the normal weight of U.S. stocks be in a portfolio? Traditionally, the asset management industry has answered this question based on Modern Portfolio Theory, which would have an individual’s portfolio reflect the “market portfolio,” or the makeup of all investable assets. This is commonly known as the capitalisation weighting—the more an asset is worth, the larger its share of your portfolio.
Market cap-weighting is one place to start
One downside of cap weighting, however, is that it is determined by stock prices. As already discussed, prices can depart from fundamentals—thus, investors’ preferences and biases can affect capitalisation. The result has been that economies with well-developed stock markets have attracted more capital, while those with developing markets have attracted less capital. This has been exacerbated by the fact that most cap-weighted global benchmarks count only the “free-float” or traded portions of markets (curbing global weightings to emerging markets like Russia and China).
The result can be significant discrepancies between the size of a country’s stock market and the size of its economy. For example, while U.S. stocks claim about 55% of the global universe, the U.S. economy composed just 24% of the 2017 global economy as measured by the World Bank[i]. The U.S. punches well above its weight in this regard, while China, for example, contributed 15% of 2017 global GDP but composed only about 3% of global indexes. The message is clear—developed markets are generally over-represented relative to their economies and emerging markets underrepresented.
So, what’s the right weighting?
We don’t believe that GDP data represents the best baseline for asset allocation, either. In our view, it is best to consider markets holistically, and the key inputs to this thinking is summarised as follows:
- Opportunity: It makes sense to look at the entire opportunity set, rather than focus on a singular market. When appropriate, we’d prefer to add niche positions that enhance the reward for risk across a portfolio.
- Portfolio constraints: If we are limited to open-ended funds, the portfolio may be shaped differently compared to a portfolio that has the flexibility to access nuanced opportunities (for example, via ETFs). That is, we may think the U.S. market is overpriced, but components within it may be far more reasonably priced (such as U.S. healthcare or consumer staples).
- Costs: All else being equal, we should favour the lowest-cost investments. We must always consider the opportunity set on an after-cost basis, which gives major markets like U.S. stocks a subtle advantage.
- Risk management:S. stocks have enjoyed a steady climb for nearly a decade. Even the recent volatility hasn’t brought valuation measures in line with historical norms. This tells us that future returns for U.S. stocks won’t likely be nearly as good as they’ve been since 2009. Therefore, downside risk remains and we must position to protect against a large drawdown.
- Diversification: We seek a mix of fundamentally diversified assets as this tends to buffer losses and provide good risk-adjusted rewards for multi-asset investors. We must embrace what we don’t know, so holding expensive assets like U.S. equities may be appropriate, although we’d prefer to hold relatively less in these assets.
We eagerly—but patiently—await a time when U.S. equity prices appear more attractive to us. This has not yet happened, despite the recent falls. Until such time, we’ll continue to favour areas that are more likely to help us meet our objectives. However, evading U.S. stocks altogether can also be a mistake, depending on the objective, especially if can take more granular positions in a portfolio (for example, investing via U.S. healthcare or consumer staples). Ultimately, deciding on the right weighting for stocks is complex, depending on the objective we’re seeking to achieve.
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